Welcome to the Currency War, Part 13: China’s Turn

It’s amazing how quickly China went from being the world’s savior to its biggest danger. To recap:

When the developed world stepped off a cliff in 2008, China responded by borrowing about $15 trillion and spending most of it on infrastructure. Roads, bridges, skyscrapers, power plants, whole cities went up around the country. The resulting demand for everything from iron ore to wind turbines helped offset contractions in the US and Europe, turning an incipient global Depression into nothing more than a severe recession.

But government-directed growth on this scale produces a mountain of misallocated capital which eventually comes back to haunt its owner. Lately, Chinese manufacturing has begun to contract:

(Reuters) – Credit warning signs are flashing for heavily indebted Chinese semiconductor, software and commodities firms as the government cautiously steps aside to let market forces play a bigger role in deciding winners and losers.

“The Chaori default goes to show the government will begin to let the market decide the fate of weak borrowers,” said Standard & Poor’s analyst Christopher Lee in Hong Kong.

Lee said defaults would be “incremental but controlled” with sectors including shipbuilding, metals and mining, and materials among those showing the highest risk as China’s economic growth slows and banks tighten lending.

A Reuters analysis of more than 2,600 Chinese companies found credit metrics worsening across a range of industries. The software sector was shouldering the heaviest credit burden with an average of 3.4 times more debt than equity. Semiconductors – a category which includes solar companies such as Chaori – had a debt-to-equity ratio of 2.6.

Materials companies look vulnerable as weak commodity prices hurt profitability, leaving less money to repay debt. Although the metals and mining sector’s average debt-to-equity ratio is a manageable 1.4, bond holders see rising risk and have demanded higher yields for holding the debt.

Other credit problems may be lurking in harder-to-read areas such as bank loans. News last week that a Chinese property developer owing 3.5 billion yuan was at the edge of insolvency highlighted that risk. About a third of Zhejiang Xingrun Real Estate Co’s borrowings came from individual investors.

Suddenly, China looks a lot like the US circa 2007, with weaker companies on the periphery threatening to infect too-big-to-fail entities at the core. How will it respond? Almost certainly with the same tools that the US, Europe and Japan have employed: bail-outs, monetary ease, currency devaluation and bigger government deficits. In other words, a major currency war offensive. This is already happening:

BEIJING—The recent sharp decline in the Chinese currency is threatening to exacerbate China’s trade tensions with the U.S. and raising concerns over a potential currency war in Asia.

China’s central bank has intervened since late February to drive down the value of the yuan against the U.S. dollar by 2.8% so far in 2014, almost erasing all of its gains last year and ushering in a rare period of weakness for a currency which has steadily appreciated over the past decade.

The People’s Bank of China argues the depreciation is needed to drive out speculators who were betting the yuan would continue to rise, according to people with direct knowledge of the central bank’s thinking.

Bank officials also contend China’s move to allow market forces to play a greater role in setting the yuan’s value has exacerbated the weakness, according to these people.

On March 17, the central bank doubled the range in which the yuan is permitted to trade—part of efforts to liberalize the financial system. Market participants, worried over recent signs of slowing economic growth, have taken this as a cue to sell yuan, Chinese officials say.

A weakening yuan is huge deal for China’s trading partners. Already, Japan has seen the yen, which it had been aggressively devaluing, rise strongly, thus threatening to derail its “Abenomics” pledge to generate at least 2% inflation. The euro is at levels that threaten to push much of the eurozone periphery back into recession. And a rising dollar/yuan will make the Fed’s attempt to scale back its debt monetization an even lower-percentage bet. In other words, every time a country tries to devalue against the currencies of its trading partners, the latter have no choice but to respond in kind, which cancels the benefits of the previous devaluation.

The solution? In his new book Jim Rickards asserts that a global devaluation against gold will be the only way to generate universal inflation. So rather than trying to depress gold, public policy will soon shift to a sudden, dramatic revaluation to between $5,000 and $10,000 an ounce.

I thought of several different responses to this piece at roughly the same time, namely:

For some reason I couldn’t care less about China, probably in part because they are so dishonest and hypocritical…

Here’s hoping that Russia takes the other side of all this and cuts to the chase, thus killing two birds with one stone: Demand all payments for its natural gas and oil to be in rubles….

I don’t know Jim Rickards personally, and I don’t mean to dump on a guy whose just trying to make a buck, but …

(Okay back to China…) When all you think is what everyone else thinks then all you will likely do is what everyone else does…

I can’t wait for Japan to implode…

(Speaking of China again…) I can’t wait for China to to implode, like Japan did in the late 1980’s. Same show, different numbers.

I think it was the myth of Confucius in our upbringing, along with generally liberal multiculturalism crap-trap, that had us all believing that an Avogadro’s number of Chinese people could and would take over the world someday.

Okay, I could mention the US and Europe, but I really am intrigued with the prospect of glimpsing Russia’s/Putin’s balls (metaphorically speaking). It’s so rich with intrigue and genuine political strategy.

I think people are going to shit when Yellen panics. She will sound like a real liberal but be in a traditionally conservative position of power. “Yikes!”, from all camps!

Europe is such a bore. It’s almost cruel to enjoy all those arrogant intellectuals stewing in their own pragmatism, but I’ll do it any way.

pipefit9

Gonzalo Lira has a recent article on China’s precarious position. He seems to think that when the when the wheels fall off over there, they will sell their stash of US Treasury Bonds and use that money to bail out their banks, after nationalizing them. I agree with the guy less than half the time, but in this case it is hard to see a different outcome.

If you have studied Japan, you would know that they acquired a lot of US Treasury debt when the Yen traded 250 or 300 to the dollar. Then their currency strengthened to 100 to the dollar, and has stayed in that range, meaning there has been a permanent devaluation of their treasury holdings of about 65%. Ouch!!

Notice how china is allowing, or even encouraging, the Yuan to weaken versus the dollar? If they are planning on cashing in some dollar chips, would it be better to get 6 yuan for each one, or 7 or 8?

I don’t know how hard the landing is going to be over there, but the idea that the folks that owe them a bunch of money (USA, EU, etc.) are going to escape unscathed is rather naive.

Bruce C

When it comes to China I honestly don’t know what to believe. (Actually that’s true for most everything these days, even scientific claims.) But considering how Russia and China have behaved for the last 5 years or so I think there is still a latent respect for the US based upon its WW2 legacy. Japan in particular was so confident that it’s military could handle the US, and maybe if US carriers were at Pearl Harbor as they were supposed to be they would have been right, but it was like the North against the South from then on.

Anyway, I think both Russia and China are wary of waking the “sleeping giant” too soon. I thought China would have taken advantage of the Fed’s QE programs to unload some of their Treasuries at higher prices, but that would have incited the US perhaps too soon. Russia could begin to challenge the “petro-dollar” system by requiring its oil and gas to be paid for in rubles, thus strengthening its currency and marginalizing the US, but that may be too aggressive too soon too.

I don’t give a damn about Japan. More precisely, I resent Japan. I like their cars and tools and consumer electronics – heck, all of their technologies – but at the same time they just seem insane.

In every case, this bit about foreign countries selling their US Treasuries as some kind of act of defiance is just a conundrum. You either own “dollars” in the form of (interest bearing) Treasury bonds, or you sell the bonds and own those same “dollars” as – well – dollars (that don’t earn jack). It’s a lose-lose situation. Ironically (and personally entertaining and satisfying, I might add) doing business with government is a losers game at all levels. And so it should be.